Wall Street speculators are reviled for supposedly profiting on others’ economic hardships. (Here is how speculation actually works). Oil prices go up, it’s speculators’ fault, and we need more controls. So you’d think if speculators were to wind up losing massive amounts on a market turn, the anti-market critics would feel that justice is finally being served.
JP Morgan’s recent $2 billion loss on derivatives positions would seem to be a perfect instance of the critics’ conception of economic justice. Not only did JPM lose this money, but the big bank did so by coughing it up to a group of “little guys” in the market. This should be just the kind of market event to make the critics happy. But of course they are not happy precisely because it was a market event—an event proceeding from voluntary exchange rather than the enforced edict of those who know better what do with other people’s money. So the critics manufacture reasons to fear the outcome, JPM’s loss, and to impose more controls.
Let’s be clear on what happened at JPM. JPM’s main business is taking in money from bank account despositors and lending it out to people who can profitably invest it. Depending on the state of the economy, there’s a greater or lesser chance that these investments won’t pan out, the borrowers will default, and JPM will be stuck with the bill. In order to mitigate or hedge this risk, JPM takes on positions in derivatives—financial instruments whose values fluctuate, in this case, based on the performance of indices representing different parts of the economy—that would tend to offset losses from a hypothetical market-wide deterioration in the credit quality of borrowers.
The derivatives positions are varied, including both long and short positions in individual markets, and are, therefore, complicated to risk-manage. The size of JPM’s hedging operation, which goes by the name of the Chief Investment Office or CIO, is such that not only does it just participate in a number of markets but it constitutes by far the largest player in some of them, so large that these particular markets simply could not exist with any comparable liquidity—the ability to buy and sell on demand—but for the CIO.
In return for this beneficent amount of liquidity, JPM had acquired a substantial influence over prices within certain markets. Critics would even warn they possessed a dangerous amount of power here. But providing liquidity only gets you so much, and the reality of underlying economic conditions is not altered at JPM’s whim. When a large player holds up price movements that such conditions bring about, the forces of a correction begin to build and sometimes make themselves known with a wallop.
This particular $2 billion wallop was painful for JPM, but not crippling. Even if we take the critics at their word in expressing a genuine concern for the institution, their proposed response is fanciful. They would legally prohibit banks from speculative trading in derivatives (under the “Volcker rule” as part of the still-unimplemented Dodd-Frank legislation). But it’s not at all clear that the CIO was speculating (i.e. taking on additional risk to earn higher returns) as opposed to attempting to hedge pre-existing risk in JPM’s other portfolios. So it’s not clear that the Volcker rule would have made any difference.
One wonders how the critics think un-incentivized government bureaucrats will be capable of distinguishing between a complicated portfolio of hedges and an attempt to take on additional risk through derivatives, when the very experts whose bonuses depend on doing so were evidently not up to the task in this instance.
This is not to say that risk management by large Wall Street firms has been exemplary in recent years. But at least profit-seeking bankers have reason to care about getting it right and so to hire people with a fighting chance. Bureaucrat regulators, put in the place of a bank’s own risk managers by government fiat, have no reason and no chance. If you want better risk management, begin by asking what institutional factors lie behind the banks’ historical risk management failures.
The real answer resides in the distorted incentives arising from previous bouts of financial regulation authored by the preening dilettantes we know as Congressmen. Principally, these are: (i) government deposit insurance, which severs the ultimate wealth-holders, the depositors, from any concern with how that wealth is invested, and (ii) the erratic, discretionary policy of bailouts for favored financial institutions, which numbs owners and managers to the chastening pain of losses.
We’re on a century long run of believing that the government can use its powers of control and expropriation to magically create a world of automatic financial safety and dependable economic growth. When the interventions sold as doing just this wind up introducing systemic weaknesses into the financial system, the interventionists’ response is always to insist on the need for more interventions, but never to question the original interventions that actually caused the problems in the first place.
This is how each intervention has provided political leverage for the ones that follow, hoisting us along a path of diminishing financial freedom—from state regulations that froze bank liquidity, to a centralized Federal Reserve system and ultimately a fiat currency that unmoored the money supply, to government deposit insurance that severed risk management from the market discipline of scrupulous despoitors, and now (or soon) to Dodd-Frank and a new set of financial mishaps. The only way to escape the cliff at the end of this path is to start questioning the original errors that started us down it.
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