WASHINGTON – The $2 billion trading loss at JPMorgan Chase has renewed calls for stricter oversight of Wall Street banks. Two years after Congress passed an overhaul of financial rules, many of those changes have yet to be finalized.
JPMorgan's misstep gives advocates of stronger regulation an opening to argue that regulators should toughen their approach.
The Obama administration has argued that it went as hard on banks as possible without further upsetting global finance. Now Democratic lawmakers and administration officials say JPMorgan case proves that more change is needed.
The loss "helps make the case" for tougher rules on banks, Treasury Secretary Timothy Geithner said in a speech Tuesday. Regulators and the Treasury Department "are going to take a very careful look at this incident of course, and make sure that we review the implications of what that means for the design of these remaining rules," he said.
Still, many in the industry warn against reading too much into one trading loss. They say losing money is an inevitable part of taking risk, as banks must.
Some fear that after JPMorgan's announcement, regulators will greet industry concerns with more skepticism as they flesh out key parts of the overhaul law.
Here's a look at four key parts of the financial overhaul and how they might be affected by JPMorgan's losses:
THE VOLCKER RULE
This provision restricts banks' ability to trade for their own profit, a practice known as proprietary trading. It is named for former Federal Reserve Chairman Paul Volcker.
— Battle lines: Banks say it disrupts two of their core functions: Creating markets for customers who want to buy financial products and managing their own risk to prevent major losses.
They say proprietary trading was not a cause of the 2008 financial crisis and the rule is a means of political revenge on an unpopular industry. Advocates of stronger regulation argue that the rule would have prevented JPMorgan's loss. They say the trades were made to boost bank profits, not to protect against market-wide risk.
— State of play: A draft of the rule satisfied neither side. It includes exceptions for hedging against risk and for market-making, but banks say they the exceptions are too narrow and difficult to enforce. It's nearly impossible to tell whether a bank bought or sold something for itself or for customers.
— JPMorgan effect: Attitudes about the Volcker rule are likely to shift as a result of JPMorgan's disclosure, experts say. Even if JPMorgan's trades truly were a failed attempt to protect against risk, the resulting loss strengthens the argument that regulators should err on the side of scrutinizing trades.
ENDING 'TOO BIG TO FAIL'
During the 2008 financial crisis and the bailouts that followed, the government was unwilling to let the biggest banks fail, for fear of upending the financial system. As part of the overhaul, Congress created a process to shut down financial companies whose failure could threaten the system.
— Battle lines: Most players agree that this is a good idea, despite some differences on the details.
— State of play: The Federal Deposit Insurance Corp., the agency responsible for closing smaller banks that falter, has taken the lead on writing rules to shut down big firms. Most observers believe that the FDIC, under acting chairman Martin Gruenberg, is on track toward creating a system that markets would trust to close a big bank.
Banks have been working with regulators to create "living wills" detailing how they would wind themselves down without disrupting markets. This exercise has forced them to look more deeply at their operations — a defense against the accusation that banks have grown "too big to manage."
However, U.S. regulators can't do it alone. A big problem after the failure of Lehman Brothers investment bank in 2008 was what to do with its overseas operations. It wasn't clear which regulators were in charge, or whose bankruptcy court would control the disposal of Lehman's assets.
Regulators are negotiating with their European counterparts, but it could take years before they agree on rules that would allow a global company to dismantle itself without spreading confusion through the financial markets.
— JPMorgan effect: Like other banks, JPMorgan supports giving the government the power to dismantle a failing bank. CEO Jamie Dimon said so clearly in an appearance on "Meet the Press" on Sunday. JPMorgan's loss probably doesn't affect the likelihood that regulators will break up a bank in the future. The loss wasn't nearly big enough to threaten JPMorgan with failure.
JPMorgan's bets involved complex investments known as derivatives whose value is based on the value of another investment. Before 2008, many derivatives were traded as individual contracts between banks and hedge funds, without any transparency for regulators. The financial overhaul sought to bring more derivatives onto regulated exchanges and force derivatives traders to put up more cash in case their bets turned against them.
— Battle lines: Overhauling the rules governing this market, estimated at $650 trillion, has proved as complex as the investments themselves. Banks support many parts of the overhaul but generally argue that forcing too much transparency would make it harder and more expensive for companies to use derivatives as a hedge against risk. They say it is an unnecessary cost that would be spread across all types of companies.
The agency most responsible for implementing these rules, the Commodity Futures Trading Commission, faces the threat of a much smaller budget than it says it needs to write the rules and increase its oversight of the derivatives market.
Advocates for stronger regulation argue that the new rules apply to the sorts of derivatives believed to have magnified the financial crisis — and JPMorgan's losses — but do not threaten investments like energy futures, for example, which airlines use to control fuel costs. They say banks are just trying to protect a lucrative business that other companies can't compete in today.
— State of play: About half the rules are done, but many crucial questions have yet to be decided. The rules will be phased in this fall through next spring. Banks are lobbying hard to protect their hold on this profitable business. Banks support pending legislation that would limit U.S. regulators' control over derivatives trades by their overseas affiliates.
— JPMorgan effect: Fairly or not, JPMorgan's big loss on derivatives trades is likely to revive scrutiny of that market. That could give advocates of tighter rules some juice in ongoing negotiations with regulators. It also could empower those who believe the budgets of the CFTC and Securities and Exchange Commission should be increased to reflect the need for broader oversight.
The overhaul calls on the Federal Reserve to oversee the biggest and most important financial companies and apply a stricter set of standards for financial fitness. For example, the companies must hold more capital as a buffer against future losses. Before, the biggest banks were overseen by a patchwork of regulations.
— Battle lines: Industry officials say they're working with regulators to fine-tune how big companies will be overseen. They are concerned, for example, about the extra costs imposed on the big companies to offset the extra risk they create in the financial system.
— State of play: Industry officials say many of these changes were happening behind the scenes even before the financial overhaul was passed in 2010. They say banks already are better capitalized and meet other standards laid out by regulators.
It's still not known exactly which financial companies will fall into this category. The biggest banks are included automatically. Regulators have more discretion when it comes to what are known as non-bank financial companies, such as huge insurance companies. Companies on the margin reportedly are lobbying hard to avoid this designation.
— JPMorgan effect: As the nation's biggest bank, JPMorgan automatically will face stricter oversight. The trading loss there is unlikely to affect detailed negotiations about how exactly such companies will be overseen.
Daniel Wagner can be reached at www.twitter.com/wagnereports .