The news of massive trading losses in JPMorgan's Chief Investment Office renewed calls for strict implementation of the Volcker Rule, the section of the Dodd-Frank Act restricting banks from proprietary trading. In my mind, the episode highlights the importance of intelligent and comprehensive risk-management procedures. While provisions such as the Volcker Rule can play a useful role, they cannot serve the desired purpose of mitigating risks to the financial system without robust risk-management standards enforced by regulators.
Without direct insight into JPM's practices, we must rely on press reports describing both the trades and the bank's risk-management practices. An emerging story describes the weakness of the bank's board-level risk oversight committee. (The three-person committee included the president of the American Museum of Natural History.) However, the facts also point to failures in the bank's risk-management culture. As with the financial crisis of 2007-08, outsized losses are primarily a function of bad management practices. The bank clearly failed to institute basic controls on the CIO's overall positions, including simple limits on the unit's gross and net positions; while such limits can be arbitrary, the unit's huge positions should have been a red flag to the bank's risk managers. (When one of your traders is likened in the press to a whale, you're too late.)
A common sentiment is that a strict interpretation of the Volcker Rule, which would virtually eliminate banks' abilities to take on proprietary trading positions, would be an effective shield against the broad systemic risks posed by huge financial institutions. While the rule seems reasonable and may have prevented this debacle, there are limits to its reach and effectiveness. In addition to being extremely difficult to define and implement, the rule doesn't limit the financial system's exposure to the failure of a large institution. For example, it is extremely difficult for regulators to differentiate between "proprietary trades," "hedges," and positions taken as part of normal dealer activities. (It's unclear whether JPM's losing positions can actually be considered "hedges.") In addition, the rule is directly applicable only to institutions holding "insured deposits," which means that it wouldn't have applied to either Bear Stearns or Lehman in 2008.
While arguably limiting a single institution's risk exposures, limits on proprietary trading cannot mitigate the risk that the failure of a major institution could result in a financial panic. As I see it, we cannot rid the modern financial system of systemic risks and "too-big-to-fail" institutions. We cannot return to the simpler financial system of 30-40 years ago, given the growth of the shadow banking system (e.g., the repo market), the markets for swaps and contractual derivatives, and securitized assets. It is not in our power to eliminate TBTF institutions; we can hope only to minimize their risk of failure and effectively manage the fallout in the event that a large institution does collapse.
It also should be understood that too-big-to-fail is imbedded not only in the financial system but also in the very fabric of 21st-century existence. We live with a variety of markets and institutions that cannot fail without catastrophic results. We discovered last year that nuclear reactors cannot be allowed to fail; moreover, our entire system of national defense is based on the notion that neither the people nor the systems responsible for monitoring other countries' nuclear arsenals can fail.
In this context, the Volcker Rule is best viewed as one of a series of measures that would help control risks to the financial system. It is equally important for regulators to focus on making sure that financial institutions have robust risk-management policies and procedures in place.
Bill Berliner is Executive Vice President of Manhattan Capital Markets. He is the co-author, with Frank Fabozzi and Anand Bhattacharya, of the recently- released second edition of Mortgage-Backed Securities: Products, Structuring, and Analytical Techniques. His email address is bill_berliner@manhattancapitalmarkets.com.
