On Friday, JPMorgan Chase declared that its chief investment office had lost $2 billion from what CEO Jamie Dimon attributed to “sloppy” and “stupid” behavior. President Obama and others have seized on the news in order to further their financial regulatory agenda, but consumers and taxpayers ought to consider a few salient facts about this incident and our financial system before signing on to ruinous new rules from the federal government.
First, the loss was small. JPMorgan has more than $2 trillion in assets, so this error poses no threat to its depositors, creditors, or counterparties. It’s only drawn such attention because the bank has done well in recent years and has accordingly been in a credible position to argue against stifling new proposals from Washington. Furthermore, none of the trades the bank made were known to be problematic ex ante. Even the intrusive Dodd-Frank Act would have sanctioned them if, as has been reported, they were made in order to hedge risk.
Despite these inconvenient particulars, our President and many federal legislators are pretending they predicted this occurrence and that their ingenious rules would have prevented it. Unfortunately for them, the history of financial regulation is checkered at best. Federal and state banking laws have contributed to instability since the 1800s, when they were responsible for numerous banking panics and failures. In the years leading up to the recent financial crisis, they encouraged financial institutions to load up on Fannie Mae and Freddie Mac’s residential mortgage-backed securities. This temporarily boosted bank profits and promoted affordable housing goals but culminated in disaster for taxpayers and homeowners.
Why, however, is financial regulation so prone to failure? Economic theory suggests a few reasons. First, government employees do not face the same incentives as the private sector actors they are charged with supervising. Working in the financial sector is particularly lucrative relative to a job at the SEC or Federal Reserve; the most talented financial engineers are as wont as any of us to maximize their salaries, meaning that those who end up as regulatory staffers are more likely to play catch up than successfully anticipate new problems. Also, compensation is not truly performance-based: Federal regulators may lose their jobs in the event of unforeseen calamities but are otherwise generally paid the same for declaring institutions sound or troubled. Banks know this and create incentives for regulators to play along: Notoriously, Robert Rubin left Goldman Sachs for the Clinton administration only to end up at Citigroup. What would his post-Treasury employment prospects have been had he been harsh to finance?
By contrast, examine the incentives of those ever-maligned short-sellers. Jim Chanos smelled trouble at Enron, David Einhorn called Lehman’s bluff, and John Paulson had doubts about the mid-decade U.S. housing market. All three profited extensively because they did research and detected problems long before federal regulators started looking. Thousands of others like them have the same incentive to perform due diligence and, indeed, they do so every day. Their record is significantly better than the regulators’ precisely because their fortunes are on the line.
Americans should capitalize on this and take financial institutions off the public balance sheet once and for all. Eliminating massive subsidies like federal deposit insurance and the promise of bailouts in the event of trouble will permit us to stabilize the financial system while saving taxpayers billions of dollars. Who could better police the behavior of smart, selfish financiers than other savvy investors with adverse interests?
President Obama is now under attack for having described JPMorgan as “one of the best-managed banks.” He shouldn’t be: Investors seem to feel the same way even in light of the recent loss. Where he goes wrong is in thinking that his bureaucracy is more likely to detect a problem than millions of minds acting on dispersed knowledge and the desire to make money. We ought to rely on those with skin in the game to regulate our financial institutions. They’re much better at it — just as economics tells us we should expect.