In fairy tales, a knight sets out on a noble mission -- saving a princess and the like -- only to be brought to harm by good intentions that meet harsh reality. Usually, the harsh reality is a nasty troll or similar evil creature that lures the unsuspecting good knight. For Jamie Dimon, the good intentions were the bank’s effort to anticipate the complex capital regulations and mind-numbing accounting standards that govern the dizzying derivatives positions the bank used to hedge risk in its Chief Investment Office (CIO). And, as we learned at the Senate Banking hearing, the troll offered the witches’ brew of inappropriate compensation incentive and risk-management lapses that persuaded the knight to get off the road, look under the bridge and meet his doom.
Mr. Dimon’s testimony spared us each step on the bank’s road to perdition at the hands of the London Whale. This is partly because the bank and its regulators are still figuring out who did what to whom how, and also prudence in the face of another set of characters straight out of a gothic fairy tale, the plaintiffs bar in securities litigation. However, as I understand it, the bank started its saga with something regulators rightly encouraged: rebalancing a huge position to anticipate the Basel II.5 trading-book capital regulations. These were only finalized by U.S. regulators in the last few days or so, but JPM knew they were coming here and already in effect in the European Union. Thus, doing what Mr. Dimon said the CIO did – reduce risk weightings in advance of Basel II.5 – was an astute, forward-looking way to ensure that the bank complied with a new rule without doing undue damage to its business model. So, what went wrong. First, the world’s a dangerous place as any good-hearted knight walking alone in the EU’s woods will tell you. So, the reduction in risk weightings was made even harder by growing risk that foiled rebalancing at many a turn. But, even before the knight got to the evil troll, it tried to do another good deed: handle its risk-weight rebalancing without incurring so much earnings volatility under applicable accounting rules that risk would materialize all over again. So, to address the mark-to-market differences between the accounting standards governing the banking book (where many of CIO’s assets live) and the trading book (where the hedges go), the bank took on still more complex positions designed to do all of this at once without stumbling off the true path.
In fairy tales, knights often meet their end by looking into things they were told to avoid before setting out on their campaign. In JPM’s case, the thing not to do was long and well understood: don’t pay traders like hedgers and expect them only to accomplish noble risk-management ends. And, if any position owns a market, it isn’t a hedge and it can’t be held as such.
Which brings us back to the troll. Mr. Dimon told Senate Banking, as he has said before, that the bank knows it did wrong, falling for what he describes succinctly as “stupid” failings. But, so far, Congress and the regulators have not confronted their own role in this saga. They are not the troll, but they feed it by piling complex rules atop others without a clear understanding of how each rule intersects with the other and establishing clear, top-level governance standards to which they and the big banks can be held readily and meaningfully accountable. Some have said JPM is “too complex to exist” or “too big to hedge.” Maybe so, but we’ll never know if all of the rules to which the bank is subject are themselves so complex that even a bank trying to manage itself properly can’t do right to save itself.
Should we break up big banks? Maybe, but a first and better step would be to issue rules that make sense when taken as a whole, doing so in concert with finalizing the orderly-liquidation standards that ensure that, when a bank fails to understand the rules, only shareholders suffer.