Guest post by Dale Gunther
A little over a month ago, JP Morgan Chase CEO Jamie Dimon announced a $2 billion trading loss. The cause? Complex derivatives on credit default swaps—the same instruments that were a major cause of the 2008 financial meltdown, from which the country is still recovering.
How did this happen? Didn’t legislators and their thousands of pages of new regulation promise to prevent these errors from occurring again? Why are Wall Street banks making the same mistakes they made four years ago that had such serious repercussions?
The London-based JP Morgan trader responsible for the blunder worked in a small unit of JP Morgan known as the chief investment office, which ironically was tasked with managing risk for the bank. This unit placed enormous, risky derivative bets using what Dimon called a “synthetic credit portfolio.” In short, the trader bet on the continued economic recovery using a complex web of trades, but lost many of the bank’s derivatives positions when prices fluctuated.
These bets attracted intense scrutiny in the hedge-fund community in the weeks before the blunder, and even raised concerns among media outlets like The Wall Street Journal, as noted in a front-page story a few weeks before the loss. The only ones that didn’t seem to notice the risky venture were bank regulators and Dimon, who at the time called the speculation a “tempest in a teapot.” Just a few weeks later, the bank’s CEO admitted the bank’s strategy was “flawed, complex, poorly reviewed, poorly executed and poorly monitored.”
Much of the resulting media coverage has focused on how such an “egregious mistake,” as Dimon called it, was allowed to happen. But the entire episode is not really about a large trading blunder, but about banks that are too big to fail. If a well-managed company like JP Morgan can allow a single overconfident trader to lose billions, how can a handful of regulators ensure a behemoth bank’s full compliance of regulation that is supposed to prevent systemic risk?
Dimon and his executive team claim they didn’t know the extent of the situation to realize the danger. The sad truth is that they didn’t have to because they understand the reality: JP Morgan is so big it will not be allowed to fail. It is so big that any massive losses will result in government aid to prop it up.
JP Morgan, along with four other U.S. banks—Bank of America, Citigroup, Wells Fargo and Goldman Sachs—held $8.5 trillion in assets at the end of 2011, equal to 56 percent of the country’s economy, according to Bloomberg Businessweek.
This worries many, including four current Federal Reserve presidents: Richard Fisher of Dallas, Esther George of Kansas City, Jeffrey Lacker of Richmond and Charles Plosser of Philadelphia. They have all expressed concern that such a concentration of assets in the banking industry threatens the financial system. They also argue that recent reforms like Dodd-Frank have not and will not eliminate too-big-to-fail banks. When a bank holds such a substantial share of U.S. wealth, there is no way the government won’t bail it out because a collapse would cripple the economy, causing the exact problems we’ve seen over the past five years.
Other Federal Reserve officials, including the head of research at the Federal Reserve Bank of Dallas, recently called for the government to break up the country’s largest banks. He posited that only smaller banks—not more regulation—will prevent another crisis.
I and other community bankers echo this sentiment. JP Morgan’s latest debacle demonstrates how too-big-to-fail banks make their money: by making enormous, complicated, risky bets in hopes of huge returns, while community banks choose to do it the old-fashioned way: holding deposits, then lending that money back out to small businesses, creating a small margin in the process. Community banks remain focused on safety and soundness, not on squandering the hard-earned cash of shareholders. They take seriously their commitment to serving people in their local communities and being responsible stewards of their customers’ money.
Large banks, of course, are the most vocal opponents of increased bank regulation, but the implementation of such regulation ultimately doesn’t matter much. JP Morgan and the nation’s other biggest banks are simply too big to regulate effectively, and thus too big to fail, which gives them hubris to make irresponsible, risky investments that endanger the entire financial system. The only way to decrease risk and hand power back to the people is, as the aforementioned Fed official noted, by spreading funds out across smaller financial institutions. By doing so, the American people will reap the benefits of a more balanced economy, as well as the hometown, personalized service offered at local banking institutions.
Dale Gunther is vice chairman of the board of People’s Utah Bancorp, the holding company for Bank of American Fork, which is an SBA-Preferred Lender, Equal Housing Lender and Member FDIC. At the start of his 16-year tenure as CEO at Bank of American Fork, the bank had two branches and $80 million in assets; it now has 13 offices and more than $880 million in assets. Dale has served as chairman of the Utah Bankers Association and currently serves as an American Fork city councilman. This article should not be considered legal or investment advice. Seek legal and investment advice from your own qualified professional.