The recent spectacular loss of billions of dollars by the trading arm of JPMorgan Chase has led to renewed interest in the broader question of whether Washington needs to tighten regulations on Wall Street. Liberals say yes; conservatives say no.
Yet when one digs into the arguments that conservatives make against greater financial regulation, one finds that their case has, as its ultimate stopping point, the dismantling of protections that ought to be regarded as essential for a civilized society.
JPMorgan Chase’s Bet and the Volcker Rule
The latest round of debate over financial regulation can be traced to a set of bets that JPMorgan Chase made with respect to corporate bonds. When those bets went bad, JPMorgan Chase lost what was originally estimated at $2 billion but has since been calculated to be even more money.
Well, so what? Don’t investors constantly make or lose money?
They do indeed, but the problem here was that much of the money that JPMorgan Chase lost came from depositors. That doesn’t necessarily mean that any depositors will lose money, but taxpayers might. Because JPMorgan Chase is “too big to fail,” if it loses enough money in this way, the government might have to bail it out—or risk chaos spreading through the financial markets and then into the real economy.
If you think you have seen this movie before, that’s because you have. The scenario I’ve just described—on a much larger scale—figured prominently in the financial crisis of 2008. Congress responded with the Dodd-Frank legislation, which contains, among other things, the “Volcker rule.” Named for its original proponent, former Federal Reserve Chairman Paul Volcker, the rule forbids banks from using depositor funds for speculative proprietary trading—that is, for making their own bets.
Why the Volcker Rule Did Not Stop JPMorgan Chase From Incurring Its Massive Loss
So why didn’t the Volcker rule forbid the deals that gave rise to JPMorgan Chase’s recent loss? Arguably, it did.
To be sure, the Volcker rule includes an important exception: Banks are permitted to “hedge” against risk by taking otherwise forbidden positions. For example, if a bank has lent a large sum of money to a ski resort, it can hedge against the risk of default by the ski resort by taking other positions that reduce the bank’s exposure to the vicissitudes of the borrower’s business—in this hypothetical, the bank might purchase derivatives contracts that pay the bank in the event of the sort of persistent warm weather that might lead to the failure of a ski resort.
Democratic Senator Carl Levin has forcefully argued that the JPMorgan Chase derivatives contracts do not fall within the Volcker rule’s hedging exception. A hedge, Senator Levin says, must decrease net risk, but the bets that JPMorgan Chase made instead increased net risk.
Levin may well be right—although it is not always clear when a particular investment increases or decreases the net risk of a portfolio. In my hypothetical example, suppose that the ski resort fails because exceptionally cold weather renders it inaccessible for several seasons. In such circumstances, the borrower may default and yet, the hedging contract that was supposed to protect the lender also won’t pay off. More generally, think about the fact that the term “hedge fund” has come to be applied generically to high-value managed funds, and you will see that the line between hedging and speculation can be blurry.
Accordingly, both the Volcker rule and its hedging exception have been put on hold until federal regulators from several agencies promulgate specific sub-rules to implement them. Although the agencies are nearly done with their work, they did not have regulations in place when JPMorgan Chase bet the proverbial farm.
Thus, we have a very simple explanation for why the Volcker rule did not forbid the risky bets placed by JPMorgan Chase: The rule was not in effect when those bets occurred.
The Debate Over Financial Regulation
What will the regulations say when they do go into effect? Whatever the answer, Congress may eventually come to see that the Volcker rule is too permissive. If JPMorgan Chase’s losses arguably fall on the allowable side of the line, then perhaps the line needs to be redrawn. To do so, Congress could return us to the regime that prevailed before the 1999 Financial Services Modernization Act. At that time, federal law forbade the combination of commercial banks and investment banks.
However, depending on the outcome of the November election, reform might go in the exact opposite direction. Presumptive Republican nominee Mitt Romney, along with many Republicans in Congress, have vowed to repeal Dodd-Frank—including the Volcker rule—arguing that the legislation does more harm than good.
Critics of Dodd-Frank—and of active government oversight of financial markets more generally—make a number of arguments for repeal. For example, lately Governor Romney has been saying that banking regulations impose the heaviest burden on small, community-centered banks, which lack the large staff and army of attorneys that Wall Street banks can call upon to ensure compliance.
This argument sounds reasonable at first glance. After all, economies of scale can make regulatory compliance less burdensome for large businesses than for small ones. Yet Dodd-Frank itself, and the regulations being designed to implement it, already aim to lighten the regulatory-compliance obligations of small community-based banks. Moreover, it is hard to believe that concern for small banks is really driving Republican dissatisfaction with Dodd-Frank, given the role of Wall Street in bankrolling the politicians who favor its repeal.
The core of the argument against substantial government oversight is simpler. The critics assert that no matter how well-meaning, government regulators lack the expertise to write rules that keep pace with a dynamic marketplace. Consequently, they will squelch deals that would be economically beneficial, thus raising the cost of credit and undermining the productivity of the economy overall. This set of claims often rides alongside a further claim: The government, critics say, should let failed enterprises fail, and thus stop distorting the incentives of bankers who know that they themselves will not bear the burden of their bad bets.
Defenders of Dodd-Frank (and financial regulation more generally) respond that they are doing just that. During the 2008 crisis, the key government players in the Bush Administration and in Congress did not want to bail out too-big-to-fail enterprises for the sake of those enterprises themselves, but rather because, given the inter-connectedness of some important financial actors, they had to do so, or else risk crashing the global economic system. Dodd-Frank aims to reduce the risk of post-hoc bailouts by creating mechanisms that would allow large financial institutions to fail in an orderly fashion—essentially extending the sort of resolution authority that the Federal Deposit Insurance Corporation (FDIC) already exercises with respect to banks so as to cover other financial players as well.
More broadly, Dodd-Frank’s defenders point to recent experience as a rejoinder to claims that financial markets will police themselves. Perhaps that is true in theory, they say, but given the opacity of modern financial instruments and the diffusion of ownership in corporations, it is hardly surprising that real financial markets exhibit classic “principal-agent” problems.
How Principal-Agent Problems Affect Financial Markets
The principals (shareholders, bondholders, depositors, and so forth) must trust the agents (banks, other financial institutions, and their employees) to make judicious decisions on their behalf. However, an agent typically has more information than the principal does, and so the principal has difficulty monitoring the agent, thus providing opportunities for the agent to act disloyally. Put more bluntly, people who are given control over large sums of other people’s money will sometimes—perhaps often—use that money to pursue their own interests.
One might think that conservatives would be concerned about principal-agent problems. Certainly they worry about such problems in the public sector. Consider the recent scandal surrounding excesses at a 2010 General Services Administration (GSA) conference in Las Vegas. Nobody applauds government waste, of course, and so Democrats and Republicans alike roundly condemned the GSA. But conservatives used the GSA scandal as the tip of a spear that was pointed at government programs more generally. The ideologically conservative view is that government officials will spend too much because they are spending other people’s money.
The conservatives are not wrong about that. Although there are many dedicated, honest public servants, human nature being what it is, some government employees will use their position to benefit themselves rather than the public interest. In short, conservatives rightly worry about principal-agent problems in government.
But if conservatives worry about the waste of about a million dollars on a Las Vegas party, why are they not much more worried about the loss of billions of dollars by JPMorgan Chase? They would say that JPMorgan Chase lost private money, not public money, and so this is potentially a problem for investors and depositors in JPMorgan Chase, but not for government.
Yet that answer overlooks the role of the government in ensuring the soundness of the financial system. The FDIC insures bank deposits and the federal government, in extreme cases, bails out banks and other financial institutions. Thus, as we learned in the aftermath of the 2008 financial crisis, private principal-agent problems can become public principal-agent problems.
Free-market conservatives believe that they have an answer to that point as well. They say that the problem is the government intervention in the first place. The government undermines the disciplining effect of the market when it provides deposit insurance and bails out banks or auto companies.
Taking the Free-Market Perspective to Its Logical Conclusion
Yet such a view has no logical stopping point. In a minimally decent and economically stable society, government will enact laws that protect innocent people against the avarice and incompetence of their fellow citizens, as well as against the vicissitudes of the market. Deposit insurance is one example of such a measure even though—in the absence of compensating regulation—it reduces the disciplining effect of the market by diminishing depositors’ need to investigate whether banks are financially sound and honest.
No serious politician has demanded the abolition of the FDIC, at least not yet. And that is not only because it is widely appreciated that there must be at least one kind of financial institution—commercial banks—in which even unsophisticated savers can safely store their money. It is also because the harm caused by a series of bank failures would reach well beyond the depositors; systemic bank failures would harm everybody.
Nonetheless, political conservatives have embraced the market-discipline argument in other contexts. Although one can find denunciations of the bank bailouts at Occupy encampments, such denunciations are positively de rigueur at Tea Party rallies. Likewise, despite his Michigan roots, Mitt Romney opposed the government bailout of the auto industry.
The debate over “Obamacare” gives us the most chilling example of conservatives’ willingness to tackle what they consider government-created distortions of the market by throwing out the baby with the bathwater. By law, hospitals may not turn away emergency patients, even if they lack health insurance. But as the old adage states, an ounce of prevention is worth a pound of cure—and so it is very expensive for the public to “insure” the uninsured through free emergency room care. Consequently, at least some of the impetus for the effort to extend ordinary health insurance via the Patient Protection and Affordable Care Act (PPACA) was the hope of saving money in the long run.
Yet some conservatives—including Justice Scalia during the oral argument on the PPACA’s constitutionality earlier this year—have argued for a simpler, if more brutal solution: Do not treat the uninsured. One might think that this is a reductio ad absurdum of the conservative position that markets will work if only government gets out of the way. Sadly, it is not. As the debate over financial regulation illustrates, this sort of thinking appears to be gaining ground.