JPMorgan Chase and the Volcker Rule

It’s rarely good news when an obscure financial regulation becomes a front-and-center element of our national debate. It means something’s gone awry with the industry the obscure rule is supposed to regulate.

That’s exactly what’s occurring this week with the Volcker Rule, which is being discussed in the wake of last Friday’s revelation that JPMorgan Chase, one of the nation’s largest and most financially sound banks, lost more than $2 billion on complicated corporate debt investments.

The Volcker Rule is part of the Dodd-Frank financial law passed by Congress two years ago. It is supposed to prevent banks and other financial institutions that receive government backing through agencies like the FDIC from engaging in risky, speculative investments.

The problem is, no one has clearly defined what constitutes risky or speculative investments under the Volcker Rule. In fact, much of the debate this week—among financial experts, members of Congress and federal regulators—is whether the Volcker Rule even applies to the sort of investments JPMorgan was making.

Those investments were being driven by a trader based in Great Britain who was known as the London Whale because of the huge portfolio he managed. Under the complex trading game he was orchestrating for JPMorgan, the company was using debt derivatives to bet on one side of its portfolio that corporate debt worldwide would become more risky, while betting with separate investments that it would become less risky. In essence, it was trying to hedge its bets in case one side of that equation was wrong. It was, and the company lost billions, despite the hedging.

If that sounds excessively complex, it is. But it also illustrates the fact that even supposedly expert global traders—even London Whales—can’t foresee every eventuality. The Black Swan effect, the impact of events that aren’t predicted or even contemplated, can trip up even the canniest traders.

That applies to regulators, as well. If traders can’t foresee every event that might make their investment go sour, regulators can’t anticipate every sort of investment deal in which companies might be involved.

That’s not an argument for abandoning federal regulations regarding financial institutions. Banks and other firms that receive deposit insurance through the federal government, and therefore could be bailed out by U.S. taxpayers if they approach bankrupticy, should have to be more careful when investing than individuals or companies which don’t receive government support.

But investing, by definition, involves risk. And neither the best traders nor federal regulators can eliminate the possibility that an investment will lose money. JPMorgan just demonstrated that to the tune of at least $2 billion.


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