The recent brouhaha over the trading losses at JP Morgan’s Chief Investment Office (CIO) has revitalized support for the old Glass-Steagall Act, which created a regulatory wall between investment banking and commercial banking for almost seven decades, until the Act’s repeal in 1999. Under Glass-Steagall, a bank could take your deposits, or take your company public, but not both. Our country needs to rebuild that wall.
The circumstances surrounding JP Morgan’s CIO desk illuminate a fundamental problem in the financial system: greed. The CIO office was ostensibly charged with reducing the bank’s overall risk through safe hedging. In reality, the CIO office did the opposite, taking on as much Value-at-Risk as the entire investment banking division of the behemoth JP Morgan. Those “hedges” have not performed as expected, and now the bank stands to lose over $3 billion and counting. How could this happen?
The SEC, CFTC, the FBI and other enforcement officials are looking closely into this question. But the answer is rather straight-forward. In Oliver Stone’s Wall Street, the flawed protagonist Gordon Gekko brazenly proclaimed that “Greed is Good.” Wall Street has taken this message to heart. Forgetting that Gekko was supposed to a cautionary figure, many Wall Street bankers and traders aspire not just to Gekko’s wealth but also to his tactics, reveling in high-stakes profiteering that often earns them 7, 8 and 9 figure incomes.
It is industry practice to borrow as much as possible (known as “leveraging”), in order to maximize gains. Unfortunately, leveraging can turn minor adverse price movements into gargantuan conflagrations. When banks start to sink, the specter of Too Big to Fail horrifies us into re-floating them with taxpayer funds (e.g., TARP) or through the Federal Reserve’s inflationary money-printing press (e.g., Quantitative Easing). The current banking model involves privatized gains, and socialized losses — a win-win deal for the banks.
No wonder that Senate hopeful Elizabeth Warren and many others have called for the reinstatement of Glass-Steagall. Glass-Steagall would have required banks that enjoy government subsidies (like the Fed’s “discount window”) to focus on conventional loan-making, thereby limiting the banks’ ability to gamble with those subsidies. That sort of restriction makes sense. The last thing you want to do is give a gambling addict an unfettered supply of cash, but that is exactly what the Federal Reserve’s current monetary policy does for bank holding companies.
The observant reader might protest, what about the Volcker Rule? Wouldn’t it have stopped the CIO office from disguising speculation as hedging? Unfortunately, no.
The Volcker Rule, often called Glass-Steagall-lite, restricts bank holding companies from engaging in proprietary trading, or speculating for their own profit. In theory, the Volcker Rule forces banks to focus on customer loans, the way Glass-Steagall required. Unfortunately, the Volcker Rule’s current form, as proposed by banking regulators, contains many loopholes that would permit egregious speculation like that undertaken by JP Morgan’s CIO office. For instance, the Volcker Rule creates broad exemptions for market-making, portfolio hedging and liquidity management. It also creates lucrative carve-outs for the toxic activities that actually caused the recent financial crisis, like securitizations and repurchase agreements.
JP Morgan can easily bear the $3 billion loss from its CIO desk. That’s not the problem. The real issue is that other banks, and possibly other divisions within JP Morgan, may be replete with similarly mischaracterized and under-capitalized trades. Can we as a society rely on banks, which are private, profit-seeking entities, to do what is best for us all?
The banks seem to think so. Their lobbyists have inveighed upon Congress and financial regulators, assuring them that the banks have sufficient capabilities to self-regulate, free from government constraint. After all, all the major banks are full of astrophysicists and mathematicians with PhD’s from places like Harvard and MIT, and the job of these “quants” is to do nothing else but build esoteric financial models to manage risk. However, despite all that brainpower, banks continually and repeatedly sabotage themselves through excessive risk-taking. The Great Recession of 2008, the worst financial crisis since the Great Depression, is testament to that fact. Simply put, no amount of financial engineering can overcome that entirely mundane human foible: greed. JP Morgan’s CIO debacle hammers that point home. As long as banks remain profitable, there will be gross incentives for them to conjure schemes to make money in ways that put the rest of us at risk.
That is exactly why we need hard-and-fast rules, like the Glass-Steagall firewall between investment banking and commercial banking, or the similar Vickers ring-fencing regime that is gaining traction in Europe. In Macbeth, Shakespeare warned of “Vaulting ambition, which o’erleaps itself and falls on the other.” We need a simple wall like Glass-Steagall to serve as a check on bankers’ vaulting ambitions.