5 Points on the Regulatory Fallout from JPMorgan's Trading Losses

As the news of JP Morgan’s trading losses continues to reverberate around the web, (check out http://www.usnews.com/news/articles/2012/05/11/in-jp-morgan-loss-bank-regulation-advocates-see-opportunity for an overview of why there is continued debate) here are five key takeaways that I think are mostly missing from the coverage:

1. Many people are speculating that the hedge was a “bet,” which I guess is critical parlance for subversive gambling of some kind.  However, there doesn’t seem to be any reason to not believe JPMorgan CEO Jamie Dimon’s statement that the position was a hedge.  It sounds like the trade was meant to hedge some macro exposure the bank’s risk officers felt they had, and the trade went awry.

2. Any business involved in the financial markets can have individual risk exposures from a single trade, asset, or business dealing, but the risk of the firm can also be looked at as the net exposures of the collective transactions.  Even if you try to completely hedge every individual transaction, that won’t typically be feasible; thus you have net exposures from the sum of all of your individual risks.  

3. If you don’t allow banks to look at their portfolio, assess the risk from it and their other business lines, and subsequently choose whether or not to attempt to hedge to reduce that risk, you actually increase the likelihood of the bank failing (the opposite intended effect of Dodd-Frank and the Volcker rule) as you have taken away a risk management tool. 

4. Though I certainly have not read the ~850 odd pages of Dodd-Frank, I am under the impression that the rules currently proposed would allow for macro hedging, such as hedging of business risks not associated with single assets.  Thus, it would seem that JPMorgan’s trade wouldn’t be illegal.  Even if the regulations end up attempting to tie hedges to specific holdings, I would think any enterprising bank could still argue for trades that act as macro hedges by pointing at assets in their vast investment portfolio.  Of course, taken further, practically any trade a bank desires could be justified.  And that’s what you get when you try to regulate something so complex.

5. It may be nigh impossible, and will almost certainly be a waste of time and money, for regulators to concoct a definition for hedging that would be as effective or constraining as they would like.  Even in a single, simple transaction, such as a derivative sold by a bank such as JPMorgan to an investment fund, the bank will likely have resulting exposure to the underlying assets, volatility, interest rates, time, and the other variables derivatives depend on.  Will regulators be able to tell banks how, how much, and how often they should hedge each of these risks in their quest to eliminate prop trading?  How will a regulator, who almost certainly will understand the assets less than the bank, determine whether a transaction is over or under-hedged and thus has exposure that might be considered “prop?”  Congressman Frank and Senator Levin would have people believe that Dodd-Frank, and the Volcker rule in particular, are going to help the country by reducing risk and avoiding any more bank meltdowns.  Looks to me like the winners right now are financial services lawyers and lobbyists.