Coming Soon: Another London Whale Shocker?

Remember last summer? The London Whale, that blockbuster adventure thriller, triggered one chill after another as the high-risk action at JPMorgan Chase was revealed. Today, the threats posed by megabanks remain just below the surface—no crisis at the moment—but they’re equally dangerous. A major sequel this year cannot be ruled out.

Dodd-Frank, the law designed to reform the financial system, had already been on the books for two years when JPMorgan’s troubles surfaced. In an effort to figure out how it failed to prevent massive losses by one of the world’s largest banks, a Senate subcommittee investigated. This spring, it issued its report on the outsize positions taken by the bank’s Chief Investment Office (CIO)—with a lead trader known as ‘the London Whale’—and the department’s subsequent six billion dollar crash.

The committee detailed a list of concealed high-risk activities, and determined that the CIO’s so-called ‘hedging’ activities were really just disguised propriety trading, that is, volatile, high-profit trades on behalf of the bank itself, rather than on behalf of its customers in return for commissions.

Levy Economics Institute Senior Scholar Jan Kregel has taken these conclusions a step further, after analyzing the evidence. In a new research paper he makes the case that the primary cause of the bank’s difficulties was not that it engaged in proprietary trading: It was the concealment of this activity through the creation of a ‘shadow bank’, with the express purpose of this hardly-visible bank-within-the-bank being to create profits. What began as a unit to hedge risks—a safeguard—no longer served that purpose. He argues that when megabanks operate across all aspects of finance, this expansion of propriety trading becomes inevitable.

The solution, Kregel says, is not to prevent hedging, but rather to recognize that it can never be consistently profitable. A true hedging unit only generates profits when a bank’s bets on its primary investments are unexpectedly wrong. The legitimate hedge is expected to run losses most of the time, if the bank’s strategy and credit assessments are accurate. And for this reason, hedging activity should never be funded from customer deposits.

Did the London Whale revelations result in protections for bank customers—and their federal insurers—from this kind of gambling?

Dodd-Frank will reach its third anniversary in July. It mandated that Congress write 398 rules. About two-thirds of the deadlines for those rules have been missed. In addition, the hiring of regulators has been stalled in Washington, further undermining implementation of the law.

One rule that limited trading on derivatives contracts, the kind of activity that led to the London Whale debacle, was successfully challenged in the courts by a finance trade group. Another, the “Volcker Rule,” would require banks to separate consumer lending from speculative trading. It was Dodd-Frank’s most ambitious provision. Bank lobbyists have successfully kept regulators way behind schedule on finalizing it. Last week, an anti-regulatory bill to roll back other restrictions on derivatives trading passed in the House (the same bill was shelved last summer while the spotlight was on the London Whale). These are only a few examples. Attempts to reign in the recklessness are relentlessly dismantled as soon as they’re proposed.

A new bill to increase capital standards for the biggest banks has also recently surfaced. The requirement that these institutions hold less debt and more assets, sponsored by Sherrod Brown (D-Ohio) and David Vitter (R-Louisiana), would, in addition, limit the federal safety net to only cover traditional banking activities. It faces tough opposition.

I’ve written before about the limits of Dodd-Frank’s scope, and the fundamental changes we need to make in how we approach financial regulation if it is going to succeed. Kregel’s analysis pinpoints some of the key abuses that urgently need to be addressed. Despite all the obstacles, the responsibility remains to reform banks that are too big to fail, and even, apparently, to regulate.

Meanwhile, the Senate subcommittee’s report has been forwarded to the Justice Department, where no particular indictments are anticipated. Until our increasingly fragile system is strengthened, expect a remake of the London Whale story. Only the cast and crew will change.