- J. P. Morgan’s losses would not have been prevented by the Volcker rule, which specifically permits hedging.
- Instead of trying to square the circle, regulators should tell Congress it can't be done; Volcker should be repealed.
- $2 billion loss is huge, to be sure, but the expressions of horror by commentators are wildly out of proportion.
According to JPMorgan Chase CEO Jamie Dimon, his bank suffered the losses while pursuing a hedging strategy. If so, the losses would not have been prevented by the Volcker rule, which specifically permits hedging. Senators Levin and Merkley have argued that while hedging is permitted, hedging a whole portfolio - as JPMorgan apparently attempted to do - is not allowed. This is incorrect. The Volcker rule specifically permits hedging "aggregated positions" which would include efforts to hedge a portfolio. Since hedging is the main way that banks and others limit their risks, limiting its use would be extremely bad policy.
The problem is that, operationally, hedging is virtually indistinguishable from proprietary trading (also occasionally labeled "speculation") which is specifically prohibited by the Volcker rule. Whether a trade or a series of trades is a hedging transaction - an effort to reduce risk that the bank has already taken on - or a proprietary trade, a new risk that the bank is putting on its books, can only be determined by a full understanding of the bank's risk position. That is the fundamental flaw in the Volcker rule, and why the regulators who are now struggling with drafting the implementing regulation for the rule are having such difficulty. Instead of this continuing effort to square the circle, the regulators should tell Congress it can't be done; the Volcker rule should be repealed.
This does not mean that Congress's desire to curb proprietary trading should necessarily be abandoned. If the answer to the hedging/proprietary trading question cannot be determined except by knowing all the circumstances surrounding a trade, including the intentions of the trader when the trade was put on, it is not suitable for a written regulation. Instead, the same objective can be sought through a subsequent supervisory action - a review of the bank's actions by a bank supervisor to determine the facts after the event - which may then result in a penalty if the bank has failed to comply with the distinction between speculation and hedging.
The danger of the Volcker rule, embodied in a regulation, is that its attempt to draw fine distinctions between proprietary trading and hedging may prevent banks from engaging in the hedging or market-making that the Dodd-Frank Act and the Volcker rule specifically permits. The draft rule was almost 300 pages, and contained more than 300 questions that the drafters asked in order to avoid unintended consequences. This suggests the difficulty of imposing such a rule on an operating firm. It is not possible to run a real time trading operation with a lawyer or Fed examiner sitting at your elbow.
A $2 billion loss is a big number, to be sure, but a lot of the expressions of horror by commentators are wildly out of proportion to the problem. $2 billion is 1/1000th of the size of JPMorgan, and only .5 percent of the portfolio the bank was attempting to protect. It is logical that very large banks will suffer large absolute losses in attempting to protect large asset portfolios. The departure of the official in charge of the hedging program now suggests that the hedge was not fully thought through and the employee responsible, and perhaps others, must be held accountable.
What is unfortunate about the debate over the Volcker rule thus far is the sense from many of the participants that banks - because they take insured deposits - shouldn't be taking risks. Occasionally this is said to be the very underpinning of the Volcker rule. This position reminds me of the motto of Bob's Bank in the famous town of Lake Wobegone: "Neither a borrower nor a lender be." It fails to understand that banking - in transforming short term liabilities into long term assets - is an inherently risky business. Lending is risky and a portfolio of loans or fixed income securities is constantly at risk from changing economic and financial circumstances. If Congress wants banks to make loans, it must also permit banks to mitigate the risks that lending entails.
Peter J. Wallison is the Arthur F. Burns Fellow in Financial Policy Studies at the American Enterprise Institute. He was a general counsel of the U.S. Treasury Department and served as White House counsel to President Ronald Reagan.